Everything in Moderation
“Moderation is the secret of survival.”
Stocks continue to set new all-time highs. All major averages (Dow Industrials, S&P 500, NASDAQ Composite and the Russell 2000) recently made new highs, accompanied by highs in breadth. Since the beginning of the year the NASDAQ is up 16.4%, reflecting the 19.8% increase in the S&P 500 GICS Technology sector over the same period. The S&P 500 rose for the seventh straight month in a row in May and has recorded 24 record closes for 2017. Despite the move to new highs, the recent rate increase at the Fed’s June 14th FOMC meeting and unveiling of their plan for unwinding its balance sheet has diverted attention back to Fed policy and the recent flattening of the yield curve. The flattening yield curve is often interpreted as a leading indicator of an economic slowdown and eventual recession. This past week the yield of the 10-Year and 3-Month Treasuries approached their one-year low. However, according to the Bespoke Investment Group, this is not a forecast for falling stock prices. They stated that “Instances since 1990 in which the yield curve of the 10-Year and 3-Month Treasury is at 52 week lows the return for stocks was surprisingly good. The S&P 500 averaged 2.24%, 5.33%, and 9.33% over the next one, three and six months, respectively.”
The bearish view anticipates a flattening of the yield curve to be a precursor of inversion. The rate increases by the Fed are too slow in an economy experiencing excesses; this is far from the situation today. The low rate of inflation has misled bears to misinterpret the current moderate flattening. In this environment we expect that Fed policy will remain data dependent to adequately negotiate the current slow growth situation.
The Moderate Economy
The US economy remains at 2% real growth. There are many different factors limiting the upside, some of these are regulatory and demographic, but in large measure it is the technological advances in the marketplace allowing consumers to purchase more for less. It has taken nearly 10 years to restore a sense of balance in the economy. Both banking and housing were, and still are, affected by government banking regulations. The rise of the largest demographic, 85 million Millennials, is becoming fullfledged participants in the economy and the impact of innovation on everything consumer.
Banking – The enactment of many restrictive regulations during the Great Recession to limit the farreaching “destructive power” of large banks, curtailing risk but at the expense of slow economic growth by the government assuming the role of the private banking system in the recovery. The current review of Dodd-Frank may lessen some of the more onerous regulations, but a full repeal seems unlikely. The most recent “Stress Test,” which all banks passed, opened the door of opportunity for banks to seek approval
from the Fed to raise dividends and to initiate new or increase stock repurchases. This may in part, explain some of the recent flow of funds into the banking sector.
Housing – remains the largest asset for most consumers, but securing the “American Dream” is much harder today than prior to the 2000-2009 fiscal crisis. The housing market is far from stable. Needless to say, things are slowly improving as the supply/demand imbalances continue to impede steady growth. Among these problems are:
A. Regulations. Mortgage qualifications are much harder on potential homeowners, this has severely impacted first-time buyers. Building regulations have added up to 25% of the builder’s costs, and to some extent created a shortage in the supply of labor. This lack of skilled labor has affected primarily small contractors who are unable to continue building houses and have left the market. This is, in part, the result of the expansion of government disability rolls immediately following the collapse of the housing industry in 2008. Federal checks in hand, many tradesmen found additional sources of income that enabled them to remain on government assistance. With the industry in depression for years there were no new workers trained. Today, a short supply of skilled construction workers are driving builder’s costs higher, not all of which is passed on to home purchasers.
B. The Cost of Homeownership. With the median prices for new and existing homes at record levels, the percentage of homeownership is at historic lows. The median price for a new home in May 2017 is $345,800, and for existing homes $254,600, respectively up 16.9% and 5.8% over May 2016. Inventory for new homes is 5.3 months and 4.2 months for existing homes. The level for existing homes is exceptionally low and has resulted in bidding wars reminiscent of the 2005-2006 housing boom. Renters are avoiding purchasing homes because of the high prices and according to the National Association of Realtors, only 52% of potential homebuyers feel it is a good time to buy now, this is down from 62% a year ago. Instead of buyer demand creating supply, the high home prices have created disequilibrium. Lower priced or starter homes are in short supply as builders target first-time homebuyers rarely pricing homes below $200,000. Investors take advantage with cash offers to buy lower-priced homes for single-family renters. An inadequate supply of affordable housing is the problem and although housing data will remain positive, the upward trend will be erratic.
Oil Prices – once again lower prices of crude oil are being touted as an indicator of slower economic growth. But unlike housing, the problem is oversupply. OPEC plus non-members led by Russia agreed in May to extend production cuts to reduce global supply by 2% through March 2018. Since then, overall production has increased as crude has fallen into a bear market. Today, WTI closed at $43.47 a barrel, down 20.2% from its peak of $54.45 a barrel on February 23, 2017. US crude rig count peaked at 1,609 in October 2014 and hit a low of 316 in May 2016, the lowest level since the 1940’s. As of June 23, 2017 the rig count is back to 758. Breakeven levels continue to fall with about 40% of the decline coming from lower costs from equipment providers. Technological innovations in fracking have improved decline rates, meaning wells are lasting longer, producing more and fewer wells are needed to increase current output. Wells are producing below $40 a barrel with some as low as $20 breakeven. Competition is Saudi Arabia which produces at $23 a barrel. Aside from lower cost, the improved regulatory environment will add to US production and transport, opening up export opportunities. Consumers are the major beneficiary, as gasoline demand has risen while maintaining lower prices. Unfortunately, the Energy sector (XLE) is down 14.7% so far this year.
Our investment policy remains optimistic. We do not discount the possibility of a market sell off as investors become frustrated with slow implementation of stimulative policies. However, any correction should be considered a long-term buying opportunity. It is unlikely given the growing strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted. Realistically the positives from expansionary fiscal policies will take more time than generally expected. Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and moderate inflation, will result in increased earnings and multiple expansion with further upside for select domestic Large-Cap consumer, financial, industrial and technology companies. To mitigate the potential of higher-than-expected inflation and multiple compression, portfolios should include value companies exhibiting sustainable earnings growth and dividends.